Hart to heart for the tax avoiders

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The judgement in the Harts case, handed down by the High Court on Thursday, is profoundly significant for every Australian business.

The case was only superficially about using a "split loan" to buy an investment property; it was really a test case about tax avoidance, and what constitutes a scheme under Part IVA of the act - the general anti-avoidance provision.

Tax planning is in the bones of every business: every transaction and every structure is organised with at least one eye on tax.

On Thursday, the High Court, by a majority of five to nil, said that a tax avoidance scheme may be the whole transaction, when only part of it is designed to reduce tax.

The Federal Court had ruled that only the tax avoiding bit was caught by Part IVA; the High Court has ruled that the transaction itself is caught if part of it is a scheme to reduce tax. It is a stunning victory for the tax commissioner with very broad implications. It may, for example, lead to a crackdown on sale and leaseback arrangements, and a huge range of financing and structuring arrangements besides.

A fascinating and rather ironic sidelight to the case is that when the general anti-avoidance provision - Part IVA - was introduced in 1981 by then-treasurer John Howard, two key advisers on the bill had been two Sydney barristers, Murray Gleeson and Graham Hill.

Hill is now on the Federal Court and led that court's judgement against the tax commissioner in Harts in 2001. Gleeson is now chief justice of the High Court and led this week's reversal of it. Obviously the two men now disagree about what they meant in 1981.

And what's more, their honours on the High Court were pretty rough on their Federal Court brothers: Gleeson C. J., McHugh J., Gummow J., Hayne J. and Callinan J. didn't confine themselves to their opinion - they laid out chapter and verse on how Hill J and his colleagues got it wrong.

For example: "The Full Court held that it would be concluded that the dominant purpose of the respondents [Richard and Trudy Hart] in entering into or carrying out the scheme was the obtaining of borrowed money to purchase a new home and refinance what was to become a rental property. We are unable to share that opinion." (Gleeson and McHugh).

And: "It may be that respondents did wish to make an investment and to change their residence. These were entirely irreproachable and proper objectives. But the means adopted to achieve these results could readily, and should be objectively concluded to be a scheme for the (dominant) purpose of enabling the respondents to obtain a tax benefit." (Callinan)

Gummow and Hayne mercilessly picked Hill's judgement to pieces.

The above two quotes probably best explain the essence of why the Harts judgement is so important to business generally - not just split-loan borrowers like the Harts - and why, in particular, it may vindicate the Tax Office's opposition to structured arrangements like sale and leaseback.

On one reading of the Harts decision, it reverses the effect of two earlier Federal Court judgements - "Metal Manufacturers" and "Eastern Nitrogen" - which have been taken to mean that the dominant purpose of a sale and leaseback, for example, is to buy an asset, not to get a tax benefit, which means it's not caught by Part IVA.

The Hart judgement potentially changes everything.

Is the dominant purpose of negative gearing, for example, to buy an investment property or get a tax deduction? That probably now depends entirely on whether there is reasonable expectation of a capital gain.

And is a small business person's decision to incorporate in the first place - rather than operate as a sole trader or a partnership - made for the dominant purpose of gaining a tax benefit? Of course it is. The Harts judgement seems to suggest that in many cases incorporation itself might fall within Part IVA.

The fact that this week's judgement has the tax commissioner jubilant should, in itself, make everyone worried - except the lawyers, of course. Note: Many mortgage brokers have written to complain about Wednesday's column about their industry.

I do not think mortgage brokers are all liars and cheats and I'm sorry if I gave that impression. Most do a good job for their clients, and loans arranged by them usually have lower interest rates than those got directly from a bank. Also their commissions are paid by lenders as an alternative to internal wages, not directly by borrowers.

But I strongly believe the commission structure is both inconsistently disclosed and inherently flawed: upfront commissions tend to reward churn, even if many or most brokers resist that temptation, and all types of trailing commissions - whether for mortgages, wealth management or mobile phones - lock in high costs over the long term. And all costs are ultimately borne by the customer.